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LEARNING OBJECTIVES
After studying this chapter, you should be able to:

3.1 Explain how the interest rate links present value with future value.
3.2 Distinguish among different debt instruments and understand how their prices
are determined.
3.3 Explain the relationship between the yield to maturity on a bond and its price.
3.4 Understand the inverse relationship between bond prices and bond yields.
3.5 Explain the difference between interest rates and rates of return.
3.6 Explain the difference between nominal interest rates and real interest rates.

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 Will Investors Lose Their Shirts in the Market for Treasury Bonds?
Treasury bonds have little default risk as the U.S. government is almost
certain to make payments on its bonds.
In September 2012, many financial advisors warned investors not to buy
Treasury bonds due to their interest rate risk.
The Fed had responded to the weak U.S. economy by increasing the money
supply that would lead to high inflation in the long run.
The expectation of high future inflation would lower the prices of bonds as a
result of higher interest rates on those bonds.

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 Key Issue and Question

Issue: Some investment analysts argue that very low interest rates on
some long-term bonds make them risky investments.
Question: Why do interest rates and the prices of financial securities
move in opposite directions?

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 3.1 Learning Objective
Explain how the interest rate links present value with future value.

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 The Interest Rate, Present Value, and Future Value
Why Do Lenders Charge Interest on Loans?

The interest rate on a loan should cover the opportunity cost of supplying credit
so that the interest should include:

Compensation for inflation: if prices rise, the payments received will buy
fewer goods and services.
Compensation for default risk: the borrower might default on the loan.
Compensation for the opportunity cost of waiting to spend the money.

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 Most Financial Transactions Involve Payments in the Future

The importance of the interest rate comes from the fact that most financial
transactions involve payments in the future.

The interest rate provides a link between the financial present and the financial
future.

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 Compounding and Discounting
Future value is the value at some future time of an investment made today.

The future value of an investment (principal) in one year (FV1) with an interest
rate i:

Compounding for More Than One Period

Compounding is the process of earning interest on interest, as savings

accumulate over time.
If you invest the principal for n years, then you will have at the end of n years:

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 Solved Problem 3.1A In Your Interest

Comparing Investments
Suppose you are considering investing $1,000 in one of the following bank
CDs:
First CD, which will pay an interest rate of 4% per year for three years
Second CD, which will pay an interest rate of 10% the first year, 1% the
second year, and 1% the third year
Which CD should you choose?

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 Solved Problem 3.1A In Your Interest

Comparing Investments
Solving the Problem

Step 1 Review the chapter material.

Step 2 Calculate the future value of your investment with the first CD.
Principal = $1,000, i = 4%, n = 3 years
FV = $1,000 x (1 + 0.04)3 = $1,124.86

Step 3 Calculate the future value of your investment with the second CD.

Principal = $1,000, i1 = 10%, i2 = 1%, i3 = 1%, n = 3 years

FV = $1,000 x (1 + 0.10) x (1 + 0.01) x (1 + 0.01) = $1,122.11

Step 4 Decision: You should choose the investment with the highest future
value, so you should choose the first CD.

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 An Example of Discounting

Funds in the future are worth less than funds in the present, so they have to be
reduced, or discounted, to find their present value.

Present value is the value today of funds that will be received in the future.

Time value of money is the way that the value of a payment changes
depending on when the payment is received.

Discounting is the process of finding the present value of funds that will be
received in the future (i.e., the opposite of compounding).

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 Some Important Points about Discounting
1. Present value is also known as present discounted value.
2. The further in the future a payment is to be received, the smaller its present
value.
3. The higher the interest rate used to discount future payments, the smaller
the present value of the payments .
4. The present value of a series of future payment is simply the sum of the
discounted value of each individual payment.

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 Some Important Points about Discounting

Examples:
At an interest rate 5%, a $1,000 payment has a PV of $952.38 in one year,
but only $231.38 in 30 years.
A $1,000 payment you receive in 15 years has a PV of $861.35 when the
interest rate is 1%, but only $64.91 when the interest rate is 20%.
Suppose the interest rate is 10%, and you will be paid $1,000 in one year
and another $1,000 in 5 years, then the PV of both payments is $909.09 +
$620.92 = $1,530.01.
The Interest Rate, Present Value, and Future Value
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 Solved Problem 3.1B In Your Interest
How Do You Value a College Education?
The following data are the additional earnings of college graduates over high
school graduates by age:

Age 22: $7,200

Age 23: $7,200
Age 24: $7,300
Age 25: $7,300
a. What is the present value of a college education from ages 22 to 25?
Assume an interest rate of 5%.
b. Suppose you are 18 years old, explain how you calculate the present value
of a college education in order to make a decision whether to take a job
immediately after graduating from high school or to attend college and then
work at age 22.

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 Solved Problem 3.1B In Your Interest

How Do You Value a College Education?

Solving the Problem

Step 1 Review the chapter material.

Step 2 Answer part (a) by using the data given to calculate the PV of a college
education.

Step 3 Answer part (b) by considering how to calculate the PV of a college

education through the normal retirement age of 67.
You would also need to consider:
Explicit costs of attending college, e.g., tuition and books
The opportunity cost of attending college
Income of the specific occupation you intend to enter after graduation

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 Discounting and the Prices of Financial Assets

Discounting lets you compare financial assets.

The price of an asset is determined by adding up the present values of all the
payments from its sellers to buyers.

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 3.2 Learning Objective
Distinguish among different debt instruments and understand how their prices are
determined.

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 Debt Instruments and Their Prices

The price of a financial asset is equal to the present value of the payments to
be received from owning it.

Debt instruments are methods of financing debt, including simple loans,

discount bonds, coupon bonds, and fixed payment loans.
also known as credit market instruments or fixed income assets

Equity is a claim to part ownership of a firm

Example: common stock issued by a corporation.

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 Loans, Bonds, and the Timing of Payments

In this section, we discuss four basic categories of debt instruments:

1. Simple loans
2. Discount bonds
3. Coupon bonds
4. Fixed-payment loans

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 Simple Loan

Simple loan is a debt instrument in which the borrower receives from the
lender an amount called the principal and agrees to repay the lender the
principal plus interest on a specific date when the loan matures.

After one year, Nates would repay the principal plus interest: $10,000 +
($10,000 0.10), or $11,000.

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 Discount Bond

Discount bond is a debt instrument in which the borrower repays the amount
of the loan in a single payment at maturity but receives less than the face value
of the bond initially.

The lender receives interest of $10,000 - $9,091 = $909 for the year. Therefore,
the interest rate is $909/$9,091 = 0.10 (10%).

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 Coupon Bonds

A coupon bond is a debt instrument that requires multiple payments of interest

on a regular basis, and a payment of the face value at maturity.

Terminology of coupon bonds:

Face value (or par value): the amount to be repaid by the bond issuer (the
borrower) at maturity
Coupon: the annual fixed dollar amount of interest paid by the issuer of the
bond to the buyer
Coupon rate: the value of the coupon expressed as a percentage of the par
value of the bond
Current yield: the value of the coupon expressed as a percentage of the
current price

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 Coupon Bonds

Maturity is the length of time before the bond expires and the issuer makes
the face value payment to the buyer.

Example: IBM issued a $1,000 30-year bond with a coupon rate of 10%, it
would pay $100 per year for 30 years and a final payment of $1,000 at the
end of 30 years.

The timeline on the IBM coupon bond is:

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 Fixed-Payment Loan

A fixed-payment loan is a debt instrument that requires the borrower to make

regular periodic payments of principal and interest to the lender.

Example: You are repaying a $10,000 10-year student loan with a 9%

interest rate, so your monthly payment is approximately $127.

The time line of payments is: P = (R/1-(1+R)-N) Loan

R = 0.09/12 = 0.0075, N = 10 120 =120, Loan = 10k
P = 126.66 127

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 Making the Connection In Your Interest
Interest Rates and Student Loans

More students are taking out student loans and in larger amounts.
Compounding and discounting help students understand the consequences
of loan options:
1. Not making interest payments while in college: The unpaid interest is
added to the loan principal, so the monthly payments in the payback
period would increase.
2. Extending the payback period from 10 years to 30 years: Each monthly
payment decreases, but since the principal is paid down more slowly,
the total interest payments will increase.

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 3.3 Learning Objective
Explain the relationship between the yield to maturity on a bond and its price.

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 Bond Prices and Yield to Maturity
Bond Prices

Consider a coupon bond with i = 6%, FV = $1,000, n = 5 years.

The price of the bond (P) is the sum of the present values of 6 payments:

For a bond that makes coupon payments (C) and matures in n years:

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 Yield to Maturity
Yield to maturity is the interest rate that makes the present value of the
payments from an asset equal to the assets price today.
the interest rate on a financial asset for financial markets participants.

Yields to Maturity on Other Debt Instruments

Simple Loans
For a $10,000 loan required to pay $11,000 in one year:
Value today = Present value of future payments

Solving for i:

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 Discount Bonds
Consider a $10,000 one-year discount bond with a value today of
$9,200.
Value today = Present value of future payments

Solving for i:

A one-year discount bond that sells for price P with face value FV. The
yield to maturity is:

Bond Prices and Yield to Maturity

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 Fixed-Payment Loans
For a $100,000 loan with annual payments of $12,731:
Value today = Present value of future payments

For a fixed-payment loan with fixed payments FP and a maturity of n years,

the equation is:

Perpetuities
A perpetuity does not mature. The price of a coupon
bond that pays an infinite number of coupons equals:
So, a perpetuity with a coupon of $25 and a price of $500 has a yield to
maturity of i = $25/$500 = 0.05, or 5%.
Bond Prices and Yield to Maturity
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 Solved Problem 3.3
Finding the Yield to Maturity for Different Types of Debt Instruments

For each of the following situations, write the equation that you would use to
calculate the yield to maturity.
a) A simple loan for $500,000 that requires a payment of $700,000 in 4
years.

b) A discount bond with a price of $9,000, which has a face value of $10,000
and matures in 1 year.

c) A corporate bond with a face value of $1,000, a price of $975, a coupon rate
of 10%, and a maturity of 5 years.

d) A student loan of $2,500, which requires payments of $315 per year for 25
years. The payments start in 2 years.

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 Solved Problem 3.3
Yield to Maturity for Different Types of Debt Instruments
Solving the Problem
Step 1 Review the chapter material.

Step 2 Write an equation for the yield to maturity for each debt instrument.

a) A simple loan for $500,000 that requires a payment of $700,000 in 4 years.

b) A discount bond with a price of $9,000, which has a face value of $10,000
and matures in 1 year.

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 Solved Problem 3.3 (continued)
Yield to Maturity for Different Types of Debt Instruments
Solving the Problem
Step 1 Review the chapter material.

Step 2 Write an equation for the yield to maturity for each debt instruments

c) A corporate bond with a face value of $1,000, a price of $975, a coupon

rate of 10%, and a maturity of 5 years.

d) A student loan of $2,500, which requires payments of $315 per year for
25 years. The payments start in 2 years.

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 3.4 Learning Objective
Understand the inverse relationship between bond prices and bond yields.

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 The Inverse Relationship between Bond Prices and
Bond Yields

What Happens to Bond Prices When Interest Rates Change?

If new bonds are issued at a higher interest rate, holders of existing bonds
would have to adjust their bond prices.
As the bond yield is higher, the bonds market price will fall below its face
value.
So, when interest rates rise, bond prices fall.

A capital gain occurs when the market price of an asset increases.

A capital loss occurs when the market price of an asset declines.

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 Making the Connection
Banks Take a Bath on Mortgage-Backed Bonds
Banks reduce lending significantly during the financial crisis of 2007-2008.
For mortgage-backed securities, borrowers began to default on their
payments, so buyers required much higher yields to compensate for more
default risk.
By 2008, the prices of many mortgage-backed securities had declined by
50% or more. Higher yields on these securities meant lower prices.
By early 2009, U.S. commercial banks had suffered losses of about $1
trillion on their investments.

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 Bond Prices and Yields to Maturity Move in Opposite Directions

Yields to maturity and bond prices move in opposite directions.

If interest rates on newly issued bonds rise, the prices of existing bonds will
fall, and vice versa.
Reason: If interest rates rise, existing bonds issued with lower interest rates
become less desirable to investors, and their prices fall.
This relationship should also hold for other debt instruments.

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 Secondary Markets, Arbitrage, and the Law of One Price

A trader buys and sells securities to profit from small differences in prices.
During the period before bond prices fully adjust to changes in interest rates,
there is an opportunity for arbitrage.
Financial arbitrage is the process of buying and selling securities to profit
from price changes over a brief period of time.

The prices of financial securities at any given moment allow little opportunity
for arbitrage profits, so that investors receive the same yields on comparable
securities.
This rationale follows the principle of the law of one price: identical products
should sell for the same price everywhere.

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 Making the Connection
Reading the Bond Tables in the Wall Street Journal
Treasury Bonds and Notes

Bond A matures on August 15, 2015, and has a coupon rate of 4.250%, so it
pays $42.50 each year on its $1,000 face value.
Prices are reported per $100 of face value. For Bond A, 112:08 means 112
and 08/32.
The bid price is the sell price; the asked price is the price to buy the bond.
For Bond A, the bid price rose by 8/32 from the previous day.

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 Making the Connection In Your Interest
How to Follow the Bond Market: Reading the Bond Tables
Treasury Bonds and Notes

The current yield of Bond A ($1000 face value): $42.5/$1,112.81, or 3.82%.

The current yield of Bond A is well above the yield to maturity of 0.35%.
The current yield is not a good substitute for the yield to maturity for a short
time to maturity because it ignores the effect of expected capital gains or
losses.

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 Making the Connection In Your Interest
Reading the Bond Tables in the Wall Street Journal
Treasury Bills

Treasury bills are discount bonds, not coupon bonds.

Treasury notes and bonds quote prices, while Treasury bills quote yields.
The bid yield is the discount yield for sellers. The asked yield is for buyers.
Dealers profit margin is the difference between the asked and bid yields.
The yield to maturity (last column) is useful for comparing investments.

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 Making the Connection In Your Interest
Reading the Bond Tables in the Wall Street Journal
New York Stock Exchange Corporation Bonds

A bonds rating shows the likelihood that the firm will default on the bond.
Prices are quoted in decimals.
The last time this Goldman Sachs bond was traded that day, it sold for a
price of $1,152.16.

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 3.5 Learning Objective
Explain the difference between interest rates and rates of return.

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 Interest Rates and Rates of Return
Return is a securitys total earnings.
For a bond, its return the coupon payment plus the change in its price.

The rate of return (R) is the return on a security as a % of the initial price.
For a bond, R equals the coupon payment plus the change in the price of a
bond divided by the initial price.

Example: A bond with a $1,000 face value and a coupon rate of 8%.
If the end-of-year price is $1,271.81, then, the rate of return for the year is:

If the end-of-year price is $812.61, then, the rate of return for the year is:

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 A General Equation for the Rate of Return

A general equation for the rate of return on a bond for a holding period of
one year is:

Three important points:

1. For the current yield, the calculation uses the initial price.
2. If you sell the bond, you have a realized capital gain or loss; otherwise, your
gain or loss is unrealized.
3. The current yield and the yield to maturity ignore capital gain or loss, so they
may not be a good indicator of the rate of return.

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 Interest-Rate Risk and Maturity
Interest-rate risk is the risk that the price of a financial asset will fluctuate in
response to changes in market interest rates.
Bonds with fewer years to maturity will be less affected by a change in
market interest rates.

The table shows that the longer the maturity of your bond, the lower (more negative)
your return after one year of holding the bond.

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 3.6 Learning Objective
Explain the difference between nominal interest rates and real interest rates.

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 Nominal Interest Rates Versus Real Interest Rates
Nominal interest rates are interest rates that are not adjusted for changes in
purchasing power.

Real interest rate are interest rates that are adjusted for changes in purchasing
power.

Because lenders and borrowers dont know what the actual real interest rate
will be during the period of a loan, they must estimate an expected real
interest rate.
The expected real interest rate (r) equals the nominal interest rate (i) minus
the expected rate of inflation (p e).

This means that: i = r + pe

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 Nominal Interest Rates Versus Real Interest Rates
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 Figure 3.1 Nominal and Real Interest Rates, 19822012
The nominal interest rate is the interest rate on three-month U.S. Treasury bills.
The actual real interest rate is the nominal interest minus the actual inflation rate, as
measured by changes in the consumer price index.
The expected real interest rate is the nominal interest rate minus the expected rate of inflation
as measured by a survey of professional forecasters.

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 It is possible for the nominal interest rate to be lower than the real interest
rate.
This occurs when the inflation rate is negative (i.e., deflation).

Deflation is a sustained decline in the price level.

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 Figure 3.2 TIPS as a Percentage of All Treasury Securities
Since 1997, the U.S. Treasury has issued inflation indexed bonds called TIPS (Treasury
Inflation Protection Securities). TIPS were an increasing percentage of all U.S. Treasury
securities until 2009.

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 Answering the Key Question

At the beginning of this chapter, we asked the question:

Why do interest rates and the prices of financial securities move in opposite
directions?
The price of a financial security equals the present value of the payments an
investor will receive from owning the security.
When interest rates rise, present values fall, and vice versa.
Therefore, interest rates and the prices of financial securities should move in
opposite directions.

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